Should You Stop Saving and Investing When Paying Off Debt?
The concept of multitasking, for a person, is a myth. When someone says they are multitasking, they are quick task shifting. We can move our attention quickly from one task to the next, and shift back again, but it’s practically impossible to focus on two different things at the same time. To excel at anything requires undivided attention. Just ask an athlete who performs at world-class levels; the intense focus required to achieve at high levels doesn’t allow for multitasking.
It doesn’t take an Olympic athlete’s training and dedication to be successful when paying off debt, though. A solid debt repayment plan does not require 100% of someone’s focus. Should is require 100% of someone’s cash flow, though? To focus on paying off debt, should households suspend other financial goals like saving for retirement and setting up an emergency fund?
Saving in an emergency fund
An emergency fund is so important that it should be at least started before embarking on a plan to aggressively pay off debt. Without an emergency fund, if an emergency were to befall a household while all extra cash is designated for paying off debt, the only option for meeting the needs of that emergency might be going further into debt. With an emergency fund, you may have delayed the target date for being fully debt-free, but if an emergency occurs you’ll be able to handle at least part of the financial problem. A cash cushion will make paying off debt easier and will reduce stress levels.
If you can save just $1,000 in a high-yield online savings account, you’ll start a debt reduction plan from a much more stable position. It would be even better to have one month’s expenses saved away, with the rule that these funds would not be touched unless faced with a true emergency. Although the Debt Snowball and the Debt Avalanche prescribe putting all extra cash flow to paying off debt, establishing an emergency fund should be a parallel goal.
Saving for retirement
Saving or investing for retirement should, for the most part, be not put on hold, either. Don’t decrease your 401(k) contribution with the intent of putting extra money towards debt. You should invest enough to take advantage of any company match, because that could be an automatic 100% return for your money, and you can never get that back if you skip it. 401(k) contributions are tax deductible, another benefit you’ll lose if you reduce your contributions.
If your debt load is significant and ceasing your retirement contributions is the only way you could just meet your minimum payments, it may be justified to forego the benefits of investing in a 401(k) in favor of defaulting on your debt. However, in most cases, you should be able to keep your retirement investing steady., and any raises or bonuses you receive, sometimes automatically invested for the future, should be used for accelerating your debt payoff.
Saving for other goals
Saving for other purposes, like buying a house, paying for your children’s education, or taking a vacation next year, can be important, but paying off debt is a primary goal that outweighs other savings. These are “wants” or luxuries. Paying off debt is a necessity for having a financially independent life. You can delay buying a house, postpone a vacation, or even find different ways to fund college tuition.
To seriously take on the goal of paying off debt and to have an expectations of results, it’s imperative to put aside unnecessary desires and focus on the task at hand. For the last ten years, a friend of mine has been trying to get out of debt, or at least she says she has been. Yet, she continues to make life choices that involve spending more money than she has, and always has an excuse ready to go to justify the decisions in her own mind. I don’t judge people for their choices. I’ll support all friends in the way they choose to live their lives, but she might be happier in the long run once she decides to seriously prioritize getting out of debt.
Making sacrifices is never fun, and it’s easy to feel that middle class consumers deserve certain luxuries like television, Internet access, and cellular phone service. Many middle class consumers consider these to be necessities and wouldn’t dare cutting them from their lives, but if the trade-off is spending the rest of their lives indentured to credit card issuers and other lenders while leaving their income generation possibilities up to the whim of an employer, a few sacrifices today will make life better in the future.
“Earning” your debt interest rate
This doesn’t address the financial return of saving and investing for the future. It’s common to say that paying off debt is a guaranteed “return on investment.” That is, if you are paying off debt with an interest rate of 15%, you “earn” 15% by paying it off faster. Then, this fake ROI is used as a reason for prioritizing debt repayment above investing. The interest rate you “earn” for paying off debt is compared with expected return from investing to determine which approach should have priority. A 15% APR debt should be paid off before investing in the stock market with a 6% to 8% long-term estimated return, and investing in the stock market should be prioritized above paying off a 3% APR loan.
This is absolutely the wrong terminology to use. Debt is a result of spending money. You’re earning nothing by paying off debt, you’re spending less. You’ve already spent more than the value of the items you purchased with debt, so all you’re doing by paying off debt faster is cutting your losses. It’s important to do this, but you’re not earning anything like you would, potentially, with an investment.
Nevertheless, the interest rate comparison is fine for prioritizing debt. Unless you have a spending problem, it makes sense to hold onto a 0% APR balance as long as possible, but something like an emergency fund should not be looked at as an investment or compared to paying off debt. Assume money in a savings account earns a 0% return, but recognize that the importance of having the cushion ready to supplement your income with the loss of a job or an unexpected medical expense.
What changes would you make to your spending and saving plan if you decided to accelerate your debt payoff plan?